Be a Skeptical Optimist

Every once in a while, I am accused of being a doom-and-gloomer. It happened again this weekend when a friend was saying the housing recovery would drive U.S. economic growth. I had to take the other side by pointing out that there was no lower or middle market for homes and that I had huge doubts about the actual recovery in housing being a beneficial boom.

Even Fannie Mae recently pointed out that broad economic concerns are likely to constrain the housing market this year. The company projects that this year's sales will lag last year's.

I am not a long-term bear on housing. When I look at the new single-family home sales chart at the excellent St. Louis Fed FRED (Federal Reserved Economic Data) website, it is easy to see that we have a long way to go just to get to a normal level of sales. There are still plenty of demographic and economic headwinds that could keep the sector bouncing along the bottom for an extended period of time. Housing will recover, but it is probably not going to drive strong economic growth anytime soon.

My friend accused me of being a pessimist and reminded me that all the analyst, pundits and government officials are suggesting exactly the opposite of my scenario. That actually makes me very happy, as I agree with Mark Twain's suggestion: "Whenever you find yourself on the side of the majority, it is time to pause and reflect."

Let me make clear that I am not a pessimist. I am hugely optimistic about the long term future of the U.S. and the world. However, I am very skeptical and my first question when presented with an investment idea is not, "How high can it go?" but, "What can wrong with this idea?" and, "How much can I lose if I am wrong about this sure-fire get-rich idea?"

Most investors worry about how much they can make. I find that if I focus on what can possibly go wrong, the making money part of the equation has a tendency to take care of itself.

I apply that concept to each and every stock idea I develop. It is not enough for a stock to be cheap. It has to be safe as well. If I can't find stocks that meet all the criteria, I take a pass on that particular opportunity. While I almost never talk to management, I do talk to customers. One of my problems with Lululemon (LULU) was not just the lofty valuation but the fact that none of the women I spoke with were a big fan of $100 yoga pants. One of the reasons I took a contrarian stance on Sketchers (SKX) in 2011 was that my daughters and all their friends loved the shoes and were willing to pay up for them. I sidestepped the J.C. Penney (JCP) disaster because the stock was cheap, but not safe -- and not one single person I talked with shopped there anymore.

I try to apply the same logic to all the economic forecasts. I am not going to go out and buy stocks based on a robust economic recovery scenario when I still see lots of empty storefronts. Three people on my block alone are underemployed, making at a fraction of what they made before the economy imploded. What could go wrong? When I turn off the computer and go for a walk, I see an economy that is better than it was but is still a long way from good. There is no compelling economic reason for being an aggressive buyer of stocks right now. There not enough safe and cheap stocks to justify aggressive buying either.

I try to use safe and cheap as my guideline when I hear all the forecasts, predictions and projections. I am far from a pessimist. In my lifetime I have seen the stagflation and energy crisis of the 1970s, Vietnam and malaise, the cold war, the crash of 1987, the savings and loan mess, the internet boom and bust and the most recent credit crisis. Each and every time we have muddled through, often in spite of our political leadership, and gone onto new levels of prosperity. It's called buying low and selling high and some folks (Warren Buffett, Seth Klarman and Howard Marks) have done pretty well employing that approach.

Whenever you hear some confident prediction about the economy, the market or an individual company, your first question should be what can possibly go wrong with this idea? Is this opportunity attractively priced and is there a margin of safety?